|Vladimir Jelisavcic |
By Vladimir Jelisavcic
In today's environment of uncertain equity valuations and historically low yields on corporate credit, late-stage liquidations present an opportunity to earn solid returns with much less exposure to market risk. Most of the risk of liquidations is process and timing risk. In cases where all assets have been sold, such as MF Global and Nortel, there is no fundamental market risk. Risks are reduced solely to process and timing.
When most investors think of investing in liquidations, they typically focus on just two liquidation variables: what the assets are worth, and how long it will take to get cash out of the liquidation. A critical aspect of liquidations that is not sufficiently appreciated is the risk that liabilities will be greater or lesser than originally estimated. This is an important factor because cash proceeds from asset sales, after paying secured creditors and professional fees are often shared with all unsecured creditors.
The greater the amount of liabilities, the smaller the recovery. The lesser the amount of liabilities, the larger the recovery to each creditor. The risk that liabilities will grow is called dilution risk, and that they will shrink is sometimes called anti-dilution. Exploiting these observations between the perceived and actual amount of dilutive liabilities is an example of true alpha generation in mature liquidations. These observations persist because most investors rely on liability estimates published by professionals managing liquidations. Not enough analysis is done by investors to accurately estimate liabilities by reviewing individual claims.
Investors in liquidations are essentially taking three types of risk: asset value risk (which includes costs of the liquidation), timing, and the risk of dilutive liabilities. Asset value risk is a function of market prices. Time delay reduces rates of return. Dilutive liability risk is purely process-driven and not correlated with financial market conditions. We have found from experience that dilutive liability risk is the best form of risk to take.
A liquidating debtor distributes cash from selling assets. Assets are typically sold in private transactions so that investors avoid the risk of an uncertain public market valuation. In addition, professionals running a liquidation have incentives to underestimate asset value, and overestimate the amount of liabilities. This conservative reporting posture does not alter fundamental asset values. Conservative reporting enhances their reputations as skilled professionals. It does, however, tend to lower entry prices as most investors take cues from the conservative reporting of professionals. This tendency to "under-promise" enables professionals to "over-deliver" and report a series of upside surprises as successive reports are released to creditors. This contributes to less volatility in market prices and more stable returns.
For those reasons, liabilities are almost always overstated. Liquidators take a conservative posture when estimating the amount of dilutive liabilities, and tend to overstate potentially disputed claims. Also, if liquidators try to reduce these liabilities by actively objecting to claims, certain creditors holding claims might not actively defend against these objections because of cost, or creditor-fatigue. Thus, in a liquidation, a large stated amount of liabilities is often a source of upside. Over time, the liabilities will be reduced, leading to higher recoveries for creditors with valid claims, often referred to as denominator reduction.
Hedging this liability risk is usually not possible with reference to external instruments, such as securities of comparable companies, or with credit or equity indices. However, hedging within the same capital structure may be possible in larger bankruptcy cases with complex capital structures that will change in value based on the growth or shrinkage of liabilities.
The best way for investors to understand to what extent liabilities are overstated is a "bottom-up" review of claims. Thankfully, in U.S. cases a register of all filed claims is publicly available. Investors can take a look at some of the largest claims, review any supporting documents and map out a range of scenarios. The high end of the range of liabilities might estimate that 90% of creditors' claims are allowed as valid, the low end of the range might only allow for 75%. Of course, the devil is in the details. Investors need to understand the facts of each major asserted claim and apply judgment to estimating possible outcomes.
The liquidation of Lehman Brothers Special Financing Inc. ("LBSF") is a good example of value creation through reduction in liabilities. LBSF was the customer-facing derivatives trading subsidiary of Lehman. Exhibits to Lehman's Disclosure Statement dated August 31, 2011 estimated approximately $48.4 billion of liabilities at LBSF. We initially estimated the value of LBSF's assets (consisting of cash, intercompany accounts-receivable, etc.) at $12.6 billion, resulting in a value of LBSF claims of 26% (12.6/48.4). A few months later, on February 15, 2012, a motion was filed by Lehman publicly disclosing that its estimate of LBSF's liabilities had declined by $3.7 billion to $44.7 billion. This anti-dilutive reduction in liabilities increased the value of LBSF claims by 2.2 points to 28.2% (12.6/44.7). It is our view that this is the beginning of a process of further denominator reduction that will create additional value for holders of valid LBSF claims.
I believe that investing in liquidations is the best distressed debt "business" to be in. Bankruptcies can either be reorganizations where new securities are distributed to one or more classes of debt, or liquidations with cash payouts. Investing in bankruptcy reorganizations and receiving reorganized securities can be very profitable when financial markets are rebounding from a cyclical trough, such as in 2009. However, this type of bankruptcy investment carries with it risks of misjudging a reorganized company's business value, industry trends, and the general state of financial markets and macro economy. By contrast, investing in liquidations is a process-driven strategy with much lower volatility than reorganizations. It's not a wave you can ride easily, but it offers attractive results for those willing to put in the time.
Vladimir Jelisavcic is founder and managing principal of Bowery Investment Management, a distressed debt hedge fund based in New York.